SUBJECT: Industry Directive on Qualified Intermediary Audit Reports
For Audit Years After 2004

This memorandum provides direction to the Financial Services Qualified Intermediary Audit Team (“Audit Team”) in reviewing Qualified Intermediary (“QI”) audit reports for audit years after 2004. This directive supersedes the June 2, 2003 directive with the subject “Industry Directive on Qualified Intermediary Audit Reports For Audit Years Before 2005” (the “2003 Directive”). It also incorporates optional audit procedures and reports applicable to new Section 4A of the QI Agreement, made effective in Revenue Procedure 2003-64, 2003-2 C.B. 306 and later modified in Revenue Procedure 2004-21, 2004-1 C.B. 702 and Revenue Procedure 2005-77, 2005-51 I.R.B. 1. This directive further addresses the use of Frequently Asked Question (FAQ) nos. 2 and 3, which were added in May 2005 in FAQ Section VIII, pertaining to post-2004 audit years.

The guidelines for external auditors of Qualified Intermediaries are published in Revenue Procedure 2002-55, 2002-2 C.B. 435 (“Audit Guidance”). Under Sec. 10.03.5 of the Audit Guidance, an external auditor should submit an audit plan, subject to IRS concurrence, if it is to modify or deviate from the audit procedures set forth in the Audit Guidance. The Audit Guidance further permits an external auditor to provide explanatory footnotes or addenda to its audit report. Such information may assist the Audit Team in assessing the need for further factual development in Phase 2 of their review.

External auditors have raised questions regarding the presentation of information in their audit reports for certain issues. To achieve a uniform presentation in the audit report for such issues and eliminate the need for external auditors to submit audit plans for them, the Audit Team should inform external auditors that they may present information in accordance with the instructions contained in this memorandum. To the extent these instructions are not specifically required by the Audit Guidance, they are optional for inclusion in the audit report and should not be represented otherwise. The Audit Team may represent, however, that reporting in accordance with these instructions may sometimes eliminate or limit certain audit procedures requested by the Audit Team in Phase 2.

In addition, the Audit Team should note that this LMSB directive is not an official pronouncement of the law or the Service’s position and cannot be used, cited or relied upon as such.

(1) Expiration of 2003 Directive provision to apply Notice 2001-4

Under the 2003 Directive, the Audit Team allowed external auditors specified reporting regarding partnership and trust accountholders covered by certain transitional rules of Notice 2001-4, 2001-1 C.B. 267. These transitional rules were issued pending completion of the withholding foreign partnership (WP) and withholding foreign trust (WT) agreements described in Treasury Regulation §1.1441-5(c)(2)(ii) and (e)(5)(v). These agreements were made effective in Revenue Procedure 2003-64. This Revenue Procedure further added Sections 4A.01 and 4A.02 to the QI Agreement to allow QIs two optional procedures for documenting partnership and trust accountholders that do not themselves become withholding entities.

As these Notice 2001-4 transitional provisions are not applicable for the 2005 audit year and as the Audit Guidance does not directly address audit procedures for these two new optional procedures, items (2) and (3) below describe reporting and audit steps for them. Such procedures, while not required, may assist the Audit Team in avoiding or limiting a Phase 2 request for the external auditor to perform the procedures set forth in FAQ no. 3 in FAQ sec. VIII.

Finally, if a QI has partnership and trust accounts that are neither WPs nor WTs and for which the QI has not applied either of the two optional procedures, the partners, owners and beneficiaries of such accounts are indirect accountholders under the QI Agreement and are includible in the stratum of indirect accountholders.

The Audit Team will allow the external auditor to report, as follows, information
regarding partnerships and trusts to which a QI has applied Section 4A.01, as amended in Rev. Proc. 2004-21 to eliminate the $200,000 cap imposed in Rev. Proc. 2003-64.

(A) The audit report indicates in footnotes or a separate report section:

i. the number of partnerships, number of trusts, and the associated
reportable amounts and withholdings in the aggregate that are
related to the QI’s use of this option;

ii. how the external auditor identified these entities;

iii. the number of partners to which this treatment was applied;

iv. the number of trust owners and/or beneficiaries to which this
treatment was applied; and

v. that the external auditor

a) notes that it applied the procedures in (B) and (C) below in Phase 1 to the largest of these partnerships or trusts, based on the reportable amounts the QI paid to them during the audit year; and

b) notes that it included all other such partnerships and trusts in the appropriate stratum of direct account holders (see Audit Guidance Sec. 10.04.4(a)), excluded their partners, owners and/or beneficiaries from the indirect stratum, and, if selected for review of document validity under Audit Guidance Sec. 10.03(A)(5), step 6, applied the procedures in (B) and (C) below.

(B) For each partnership or trust selected in (A)(v) above, footnotes are
allowed indicating that the external auditor:

i. reviewed the written agreement, referenced in Section
4A.01(1), for its applicable terms and found no
discrepancies;

ii. reviewed a list or other similar record, including
withholding statements, of all partners, owners and/or
beneficiaries identified in documents provided by the
partnership or trust that indicates timely receipt by the
QI of valid documentation for each partner, owner
and/or beneficiary. A description of the list or other
record and its other uses should be noted;

- that a withholding statement with allocation information from the partnership or trust for such partners, owners and/or
beneficiaries supported the amounts reported on their Forms
1042-S; and

- that no such partners, owners and/or beneficiaries were included in any collective refund claim filed by the QI for the audit year.

If the external auditor performed step (A)(i) above and found that the QI did not apply Section 4A.01 to any entity for the audit year, such finding and the identification method used should be reported to satisfy this section 2.

(C) To determine the rate of withholding that the QI should have applied to each partnership or trust selected:

i. the external auditor performed the below procedures with respect to each partner, owner and/or beneficiary selected at random using the following chart:

Number of partners,
owners or beneficiaries

Number to be reviewed

0 - 10

all

11 - 14

10

15 - 19

13

20 - 24

16

25 - 29

18

30 - 34

20

35 - 39

21

40 - 49

22

50 - 74

24

75 - 99

26

100 -199

27

200 - 499

29

500 - 4,999

31

> 4,999

32

ii. from a review of documentation for the selected partners, owners and/or beneficiaries and records of each type of reportable amount the QI paid to the entity, based on form 1042s income classifications, the external auditor determined the highest rate of withholding applicable to each type of reportable amount;

iii. the external auditor performed a spot check of each type of reportable amount the QI paid to the entity to ensure that such payments were withheld by the QI at not less than the rate the external auditor determined above;

iv. the external auditor identified the number of partners, owners and/or beneficiaries determined to be undocumented; and

v. the external auditor identified and reported the number of U.S or pass-through partners, beneficiaries, or owners, as defined in Section 2.17 of the WP agreement or Section 2.25 of the WT agreement, based on the reviews performed in (B)(ii) and (C)(ii) above.

In performing the procedures for this Section 2 as shown above, the external auditor, upon finding any failures or deficiencies, may exercise professional judgment in determining the benefit of continuing to apply the remaining above procedures.

The Audit Team will allow the external auditor to report, as follows, information regarding partnerships and trusts to which a QI has applied Section 4A.02 of the QI agreement, as amended by Rev. Proc. 2005-77 to eliminate the relationship requirement prescribed in Rev. Proc. 2003-64.

(A) The audit report indicates in its footnotes:

i. the number of partnerships, number of trusts, and the associated reportable amounts and withholdings in the aggregate to which this treatment was applied;

ii. the external auditor’s identification method for these entities, or that the external auditor determined that the QI did not apply this option for any account holder for the audit year; and

iii. that the external auditor excluded all such partnerships and trusts, as well as their partners, owners and beneficiaries, in selecting accounts for external audit purposes in Phase 1.

The Audit Team should evaluate such information in determining whether to request that audit procedures be performed with respect to such accountholders in Phase 2.

(4) Certain Foreign Estates

The Audit Team will allow the external auditor to report, as follows, information regarding accounts of deceased account holders that contain no documentation for the estate.

(A) The external auditor reported the account as undocumented.

(B) The external auditor footnoted instances where

i. the account contains correct documentation with respect to the decedent, and

ii. it received a representation from the QI that

(a) no person has been authorized to provide documentation for the estate, and

(b) either (1) the QI treated the account as undocumented, or (2) the QI treated the account as documented based on the documentation of the decedent.

(C) The external auditor did not select for spot check any account that was so footnoted.

In the 2003 Directive, the Audit Team allowed the external auditors to: (a) report information regarding Forms W-9 in accordance with section 10.03(A)(5) of the Audit Guidance without noting whether the form was the most current version and (b) report information regarding Forms W-8 in accordance with section 10.03(A)(5) of the Audit Guidance without noting whether the form was the most current version, provided that the form revision date was October 1998 or December 2000.

This reporting is modified by this memorandum. For audit years after 2004, the Audit Team should expect QIs to use the most current versions of Forms W-9 and W-8 available when opening or updating accounts. Accordingly, the Audit Team should indicate to external auditors that a QI’s acceptance of outdated Forms W-9 and W-8 as of the date executed should be reported under AG 10.03(A)(5).2 to the extent they cause a failure of one or more of the criteria of AG 10.03(A)(5).1.

(6) Reporting of Sampling Data and Documentation Cures

The Audit Team will allow the external auditor to report, as follows:

(A) The external auditor footnotes how the sample size was determined and any steps taken to insure that all accounts subject to the QI Agreement were included in the population of accounts subject to sampling under Audit Guidance Section 10.04.

(B) The footnote includes the following by stratum:

i. the total number of accounts in the population;

ii. the total number of accounts in the sample;

iii. the total reportable amounts for the population;

iv. the total reportable amounts for the sample;

v. the total withholding amounts for the population; and

vi. the total withholding amounts for the sample.

The information listed below should also be included in the footnote. This information includes the reporting of accounts determined by the external auditor to be insufficiently documented, but then cured before the audit report is submitted. While the curing of inadequate documentation is permissible, the curing process should not delay the submission of an external audit report.

vii. the total number of accounts with NRA under withholding in the sample as identified upon review by the external auditor;

viii. the total number of accounts with additional backup withholding in the sample as identified upon review by the external auditor;

ix. the total amount of NRA under withholding in the sample as identified upon review by the external auditor;

x. the total amount of additional backup withholding in the sample as identified upon review by the external auditor;

xi. the total number of accounts with NRA under withholding in the sample at the time the external audit report was submitted;

xii. the total number of accounts with additional backup withholding in the sample at the time the audit report was submitted;

xiii. the total amount of NRA under withholding in the sample at the time the audit report was submitted;

xiv. the total amount of additional backup withholding in the sample at the time the audit report was submitted; and

xv. the timeframe in which curative documentation was received for accounts identified upon review by the external auditor as having been under withheld for NRA purposes or for backup withholding purposes, and the amount of NRA under withholding or backup withholding cured.

The term “NRA withholding” refers to Chapter 3 withholding to the extent required on payments to foreign persons.

(C) If the external auditor reports a failure in Reports 7 or 9 of Audit Guidance Sec. 10.03(A)(5) because of an invalid or missing Form W-8IMY and/or the absence of documentary evidence supporting the intermediary or flow through status of any direct accountholders, the account holders or owners of such direct accountholders may be removed from the population and sample. If any are removed, the following should be footnoted:

i. the total number of indirect accounts removed from the population and the associated a) reportable amounts, b) NRA withholding, and c) backup withholding; and

ii. the total number of indirect accounts removed from the sample and the associated a) reportable amounts, b) NRA withholding, and c) backup withholding.

(7) Reduction of Sample of Indirect Accountholders

The external auditor may report that the sample size of the indirect stratum was reduced by the number of partner, owner and beneficiary accounts reviewed under paragraph 2 or excluded under paragraph (6)(C) of this document. For statistical sample purposes, however, in no event may such reduction cause (i) a decrease in the sample size of the indirect stratum of more than 15%, or (ii) a remaining sample in the indirect stratum of less than 50 accounts.

(8) U.S. Indirect Accountholders (FAQ 2)

The Audit Team should review the audit report and its footnotes to determine whether the external auditor has performed the additional procedures prescribed in FAQ 2 in FAQ Section VIII, pertaining to post-2004 audit years. These procedures entail segregating indirect accountholders who are U.S. non-exempt persons and performing for such accounts the procedures under Audit Guidance Section 10.03(A)(6).1, steps 2 through 8.

EFFECT ON OTHER GUIDANCE:

This directive should be applied in the context of published guidance such as Revenue Procedures 2002-55, 2003-64, 2004-21 and 2005-77. This directive is not intended to supersede any such guidance or law and must be construed in that context. As in the case with any issue, the QI Team members are encouraged to exercise their professional judgment in developing and resolving factual issues.